How Saudi Arabia fell in love with real estate

Kingdom CentreInvestors in the Gulf’s largest economy have a preference for property. But is it wise to be so exposed to real estate? George Mitton reports from Riyadh.

Connecting the two prongs of the fork-shaped Kingdom Centre, Saudi Arabia’s second-tallest tower, is a bridge with tall windows that gives a panoramic view of Riyadh.

Even on a clear day, roads and buildings extend almost as far as the eye can see. Riyadh is a flat and almost everlasting desert city, growing and growing as Saudi Arabia converts its oil wealth into bricks and cement.

The huge scale of the country’s construction projects may explain the enthusiasm of Saudi investors for real estate investment, which accounts for a larger proportion of investor assets than in most countries.

But is it wise for Saudi investors to be so heavily exposed to real estate, and what can fund companies offer that would increase the investment options available in the country?

A look at Saudi investor habits reveals a split mentality between an apparent risk-averse attitude on one hand – low-yielding money market funds account for 60% of assets under management, according to the Saudi Arabian Monetary Agency (SAMA) – and a passion for real estate funds, some of them closed-ended, high-risk and potentially high-yielding. The latter type of investments seem to be gaining in popularity. Assets in closed-ended funds – many of which are real estate funds – rose 13% a year between 2009 and the first quarter of this year, according to SAMA. In the same period, assets in open-ended funds such as equity and money market funds rose 4% a year.

The desire for real estate investment makes sense considering the huge construction projects under way in the kingdom. A rapidly expanding population has left the country with a housing shortage, which the government aims to address with billions of dollars unlocked for spending after the Arab spring. In addition, the government is investing in public-private partnerships to build social infrastructure – hospitals, schools and so on – while the private sector is pushing ahead with expatriate compounds and shopping malls.

“The kind of deal flow you get here is far more vibrant than any other GCC market,” says Amrith Mukkamala, head, strategic advisory, MEFIC Capital, which in addition to managing public funds sets up public-private partnerships using institutional or family office money.

The desire for closed-ended real estate funds is driving a trend that may change the nature of the industry, says Mukkamala. While Saudi Arabia’s open-ended fund market is dominated by the asset management offspring of the big banks – NCB Capital, Riyad Capital, Sedco Capital, etc – the market for closed-ended funds is open to smaller players, many of which have scooped up business in the last few years.

“What is happening is a shift, which can be a game changer for the industry,” says Mukkamala. “From an industry perspective, the industry is top heavy. The top three or four asset managers have almost 80% of the assets under management – this is the captive market that channels deposits into money market funds. When you see a risk-on scenario, moving into sophisticated products, you will see a structural change.”

It is tempting to forecast that the future of the asset management industry in Saudi Arabia will be a rising number of small players selling largely closed-ended real estate vehicles to sophisticated investors, and gradually chipping away at the dominance of the bank-affiliated managers.

Yet some people think this would be a bad direction for the country. As mentioned, Saudi investors are already over-exposed to real estate compared to global averages. According to John Sandwick, founder of Safa Invest, a sharia-compliant investment firm, the proportion Saudis invest in real estate – and private equity – is “unbelievably out of sync with the rest of the planet”. In contrast, investment in mutual funds in Saudi Arabia is low. Assets under management in mutual funds are approximately 2% of GDP compared with more than 100% of GDP in Europe or the United States.

One reason why mutual fund investing is low is that a disastrous market crash in 2006 destroyed investors’ confidence in the equity market. Even though there are plenty of equity funds – more than half the 261 public funds recently listed by the Saudi regulator, the Capital Market Authority (CMA) are equity products – these funds have faced almost continuous net outflows, according to Ali Al-Gwaiz, chief executive of Riyad Capital (see interview, pages 14-15). Al-Gwaiz believes the market may soon stabilise, with a return to growth, but this has yet to happen.

Given the distrust in equities, and a lack of fixed income funds – only eight of the 261 funds listed by the CMA are bond funds – it is understandable that many investors turn to real estate or private equity. But is it safe to have so many assets exposed to the property market? The Saudi regulator protects retail investors from closed-ended funds, with all the lock-ups and illiquidity they come with, by hitting private funds with a 1 million riyal ($270,000) minimum subscription, but public real estate funds can run short of cash and suspend redemptions too, as happened in the UAE in 2008. What if there was a crash in the Saudi property market?

Saudi investors do have access to international funds that can spread their risk. Riyad Bank has a long-standing agreement with Fidelity Worldwide Investment, which manages Riyad customers’ money on a sub-advisory basis, for instance. A recent deal between BlackRock and Saudi Fransi Capital brings a number of Luxembourg-domiciled BlackRock funds to the Saudi market for the first time, in a model which some say could become the standard for foreign asset managers looking to distribute in the kingdom.

However, Sandwick believes there is still a hole in the market, which he hopes to fill with Safa Investment Services, a managed portfolio service that will give Saudi investors access to sharia-compliant funds from around the world. Another encouraging trend is the emergence of Derayah, a fund platform operated in the kingdom

Economic indicators can inform investors about the safety of the real estate market. 

One marker that investors should watch is the slowing growth in government spending as the effect of the post-Arab spring stimulus package, launched in 2011, winds down. Government spending has grown by more than 15% a year in recent years, but this year it will grow by less than 5%, according to figures from asset manager Jadwa Investment. 

The government will still spend huge amounts on schools, hospitals and other infrastructure, but no longer is its spending rising at speeds that indicate a bonanza, and investors ought to consider this as part of their outlook planning.

Partly because of this slowdown, Jadwa Investment is predicting the Saudi non-oil sector will grow at 5% this year, a 0.5-point decline compared to last year. Because oil production is also declining, due to lower global demand and higher production in the US and elsewhere, the economy as a whole is expected to grow 3.5% this year, which is again lower than last year’s figure.

These aren’t warning signs, exactly. Fahad Alturki, head of research at Jadwa, says the process is a “normalisation” and points out that, excluding the oil sector, the Saudi economy is still growing at a pace similar to China, Indonesia and Chile. 

But the slight slowdown in growth might make investors think twice about whether rapidly rising rental prices across the kingdom are sustainable.

Of course, not every investor in Saudi chooses to put money in real estate. Anirban Kundu, chief investment officer, Saudi Re, a reinsurance firm based in Riyadh, says his firm invests most of its money in fixed income instruments, with only up to a quarter in risk assets such as equities and real estate. 

He steers away from private equity vehicles. “In this part of the world, data covering the risks we cover, especially large risks such as catastrophes, is not well documented,” he says.

“Our ability to predict our payouts from an earthquake or flood is quite low. We prefer to err on the side of caution and stay in assets that are easy to liquidate at short notice.”

Another key investor type that is unlikely to want to make private equity plays in Saudi Arabia is foreign institutions. Although foreign institutions are currently barred from investing directly in the stock exchange, there has long been talk of opening the market to them using a model similar to the Chinese qualified foreign institutional investor (QFII) programme.

If and when this happens, Saudi Arabia would be in line to join global indices, either at the frontier or emerging market level. With a capitalisation of $300 billion, the Saudi stock market is the largest in the MENA region, on a par with South Africa. 

Its inclusion in the MSCI Emerging Market index, for instance, would lead to a significant inflow of foreign capital. This capital would go to the public equity market, not private real estate investment.

It may be that nothing short of a correction in the real estate market will stop the trend of Saudi money going into property investment. With real estate funds offering such attractive yields, it is understandable that many investors, retail as well as institutional, are loading their portfolios towards property. Yet a rise in investment options would help to overcome the imbalance. 

As an example, an asset class that seems underused is sukuk. If, as is sometimes claimed, Saudi investors opt for real estate because it is uncontroversially sharia-compliant, then sukuk ought to be just as popular, seeing as every sukuk, which is a type of Islamic bond, is linked to an underlying asset such as  a building. Saudi Arabia has seen some large sukuk offerings in recent years from the likes of Saudi Electric and Saudi Aviation, for instance, but as yet there have been few offerings by smaller, corporate entities, and so the market is limited, with little secondary trading. 

Perhaps a regulatory push to introduce more sukuk to the market would inspire asset managers in the kingdom to launch some more sukuk funds and give Saudi investors more options.

©2014 funds global mena

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